Minerals, Surface Rights and Royalty Payments

Judon Fambrough Senior Lecturer and Attorney at Law

Texas A&M University

Revised November 2009 © 2009, Real Estate Center. All rights reserved. Contents

Summary...... 1 Surface Rights and Mineral Rights...... 1 Mineral Agreements Grant Ownership Rights...... 1 Exceptions to the Rule on Surface Use...... 1 Court Cases Resolve Conflicts...... 2 Minerals: Not All Substances in Ground...... 2 Other Surface Protection Measures...... 3 Negotiating Terms of Mineral Exploration...... 3 Exploration Techniques...... 3 Permission for Exploration...... 4 Liability for Geophysical Trespass...... 4 Geophysical Explorations Under Lease...... 4 Lease Considerations...... 4 Taxation of Payments...... 5 Division Orders and Royalty Checks...... 5 Division Orders...... 5 Royalty Checks...... 7 Mineral Owners' Options...... 7

iii Summary

The exploration and production of minerals, especially oil and gas, have played an important role in the eco- nomic development of Texas. Because most of the oil and gas is privately owned, a body of law has evolved in the state that defines ownership rights. One of the earliest and most significant cases decided by the Texas Supreme Court held that the mineral estate is dominant over the surface estate. The grant of the mineral lease gives the mineral lessee the implied right to use as much of the surface as is reasonably necessary for the exploration and development of the minerals. The surface owner’s consent is not required for this right to be exercised. The mineral lessee is liable for surface damages only in limited situations. Another significant precedent established by Texas courts held that the grant of an oil and gas lease gives the mineral lessee the exclusive right to conduct exploration tests on the property for the presence of oil and gas. Be- cause an oil and gas lease is silent concerning how, when and under what circumstances the tests may be under- taken, the mineral owner may wish to address these issues when negotiating an oil and gas lease. Finally, recent Texas case law has settled the issue concerning which document controls when the division order conflicts with the oil and gas lease. The division order supplants contradictory provisions in the lease until the division order is revoked. This rule places mineral owners in a dilemma: if they sign the division order, they relinquish important lease provisions but if they do not sign, they cannot receive royalty checks. However, provisions in the oil and gas lease can be negotiated that avert this problem.

Surface Rights and Mineral Rights Independent permission from the surface owner is not necessary. No responsibility exists for restoring the surface any Texans buy small tracts outside the city for resi- or for paying surface damages. Liability arises only when dential purposes. Their primary concern is to use and the lessee goes beyond what is reasonably necessary or Menjoy the surface. They may give little or no thought negligently injures the surface. to the inclusion or exclusion of the minerals at the time of The oil company or other entity leasing the minerals is the purchase because the probability of mineral activity in the area lessee and the mineral owner is the lessor. appears nil. Later, however, not owning the minerals can create serious problems. Exceptions to the Rule on Surface Use In Texas, the mineral estate is a separate interest in land that The general rule regarding surface use may be offset by nego- can be severed from the surface estate. The severance gener- tiating specific lease provisions. For example, the lease terms ally occurs in one of two ways. Either the landowner sells the could be altered to require the surface owner and mineral les- minerals and retains the surface, or more commonly, the land- see to mutually agree on the location of wells, roads, pipelines owner sells the surface and retains the minerals. If the seller and related activities. Likewise, the lease might require the fails to reserve the minerals when selling the surface, the buyer surface to be restored and surface damages paid once drilling automatically receives any mineral interest the grantor owned operations cease. On small tracts, the mineral lessee may waive at the time of conveyance. all rights to use the surface. Most lease forms prohibit drilling Whether the surface and mineral estates are severed or unit- activity within 200 feet of any dwelling on the property. ed, the rule in Texas is the same—the mineral estate dominates. Another exception arises where the mineral activity occurs The surface estate exists for the benefit and use of the mineral within the boundaries of a municipality. The mineral producer’s owner. Otherwise, the mineral estate would be worthless if the activities must conform to any valid ordinances instituted under mineral owner could not enter on the surface to explore for the police powers of the city or town. and produce the minerals. And finally, a subdeveloper may impose certain deed restric- Mineral Agreements Grant Ownership Rights tions on a subdivision to designate operation sites (drill sites) and the location of road and pipeline easements within the This rule has serious implications for surface owners who are subdivision. The procedure is outlined in Chapter 92 of the not mineral owners. Texas courts have held that mineral leases Texas Natural Resources Code. See Center publication No. 693 are not mere rental agreements as the name implies. Instead, "Subdivision Drill Sites" for more information. they are actually deeds granting limited ownership rights to After October 1, 2007, oil and gas well operators must mineral lessees for as long as the lease continues. Thus, during inform surface owners of their intent to enter to drill a new well the tenure of a lease, the mineral lessee enjoys the same rights or to reenter a plugged and abandoned well. The notice must to use the surface as any other mineral owner. be sent to the address of the first person shown as the surface These property rights can be stated in the following way: owner by the records of the county tax assessor-collector. Ap- Mineral lessees can use as much of the surface as is rea- parently, the notice is required when the permit is issued by the sonably necessary for mineral exploration and production. Railroad Commission of Texas. This privilege springs from the executed mineral lease.

1 No notice is required when: • Completely draining underground aquifers serving as the • the surface owner has waived the requirement in writing; sole source of the surface owner’s domestic and agricul- tural water supply • the operator and surface owner have entered an agreement containing alternate provisions regarding giving notice; or • Causing subsidence because of drilling or extraction meth- ods stemming from known commercial processes • the operator enters to plug back, rework, sidetrack or deepen an existing well, or to use an existing unplugged The Texas Supreme Court has ruled, however, that subsid- well to drill horizontally. ence caused by the negligent or excessive withdrawal of groundwater will create liability. Evidently, the statute imposes no penalty for failing to Several Texas appellate cases have found the mineral lessee comply. "Failing to give notice as required by this subchapter negligent for polluting fresh water with salt water. One case does not restrict, limit, work as a forfeiture of, or terminate any found the mineral lessee liable for the negligent construction existing or future permit issued by the commission or right to and maintenance of a cattleguard that caused injury to a horse. develop the mineral estate in land." In the early 1970s, the Texas courts departed slightly from the Court Cases Resolve Conflicts traditional tests of "reasonably necessary" and "negligence." The emerging standard introduces compromise between the surface Citizens who do not qualify for these exceptions and cannot owner and mineral lessee. It is sometimes referred to as the negotiate a surface-use agreement with the producer can find Accommodation of the Estates Doctrine or the concept of "due recourse only through the judicial system. regards." The precedent was rendered by the Texas Supreme The cases evolving from the conflict between surface owners Court in the 1971 decision of Getty Oil Co. v. Jones. and mineral lessees have concentrated in three areas: What is The controversy between Jones (the landowner-farmer) and reasonable use? When does negligence occur? When do the Getty Oil centered on a beam pump installed by Getty Oil on minerals belong to the surface owner? Jones’ land. The height of the beam pump interfered with Jones’ Texas courts have ruled that the following activities constitute circular irrigation sprinkler system. Jones sued for damages and reasonable use: an injunction seeking either to have a shorter type of pump • To conduct geophysical explorations on the surface, such installed or alternatively to dig a pit to lower the height of the as seismic tests present pump. • To select the best possible well sites The Texas high court ruled in favor of Jones. The court recog- nized the reasonably necessary doctrine but held that a use still • To enter and leave the well sites and other facilities on the may be unreasonable when a reasonable alternative exists. The lease property surface owner is entitled to an accommodation of estates if the • To construct, maintain and use roads, bridges, canals mineral lessee has a reasonable alternative that would serve the and other passageways necessary to transport materials, public policy of mineral development while also permitting use personnel and equipment to and from the well sites and to of the surface for productive agriculture. other facilities Later refinement of the Getty decision limited the reasonable • To use caliche found on the leased premises to construct alternatives to other methods that can be used on the leased roads and passageways land and not elsewhere. Also, any injunctions issued based on the accommodation of the estate doctrine must identify • To install and use pipelines to transport hydrocarbons and the harm that will be suffered if the injunction is not issued. waste products to points within or off the leased premises Simply citing the doctrine as the reason for the injunction is • To house employees working on the leased premises inadequate. • To install necessary storage tanks, slush pits, structures, Minerals: Not All Substances in Ground machinery and other appliances Regarding ownership of the minerals in the ground, the • To use any water, either fresh or saline, found above or courts have recognized that property rights of the surface below the surface for use in drilling and waterflood opera- owner sometimes extend below the surface. Traditionally, un- tions der common law, all matter was divided into three categories— • To inject salt water in nonproductive wells located on the animals, vegetables and minerals (which included the soil and leased premises everything in it). Hence, if the surface and mineral estates were • However, in 1939, a Texas appellate court held the min- severed, the line of demarcation lay at the surface. eral lessee liable for the destruction of movable personal This long-standing rule was re-examined by the Texas courts property (sand) that was stored on the lessee's proposed in the cases of Acker v. Guinn and Reed v. Wylie. The latter drill site. occurred more recently and was heard twice by the Texas Su- preme Court. Resolution of the issue took several years. It is the Texas courts have ruled that the following activities do not landmark decision in this state. constitute negligence: In 1949, Wylie owned the surface and three fourths of the • Failing to restore the surface when operations cease minerals in 223 acres in Freestone County, Texas. That same • Failing to fence the area of operations to restrict grazing year he executed a mineral lease for strip mining of coal and livestock from any harmful substances existing thereon lignite. In 1950, Wylie sold the surface. Simultaneously, Wylie

2 reserved an undivided one-fourth interest in "all oil, gas and • Contact the mineral lessee in an attempt to work out a other minerals. . . ." Later, Reed became the owner of the sur- land-use agreement. Basically, the agreement would re- face and brought an action against Wylie to determine whether strict the lessee’s operations to a certain section of the land the undivided one-fourth mineral interest reserved by Wylie or restrict operations from the surface entirely. Of course, included the coal and lignite. the lessee is not under any legal obligation to enter such The court held that Wylie’s reservation did not include the an agreement. coal and lignite. The decision was based, in part, on the earlier • Contact the mineral owner and work out a land-use agree- case of Acker v. Guinn involving iron ore. There the court had ment or a comprehensive surface-use and surface-damage held that the unnamed substances included in the phrase oil, clause to be included in future leases. Again, the mineral gas and other minerals must be ascertained from the intent of owner has no legal obligation to respond to the request. the parties. And, ". . . unless contrary intention is affirmatively • Attempt to purchase all or a part of an undivided interest and fairly expressed . . . the term 'minerals' or 'mineral rights’ in the mineral estate. By doing so, future mineral lessees should not be construed to include a substance that must be may have to negotiate with them when leasing the property. removed by consuming or depleting the surface estate." Reed v. Wylie clarified the Acker v. Guinn decision. The court • If all or a part of the minerals cannot be purchased from held the term minerals means the following when no express the mineral owners, surface owners may attempt to pur- intent appears to the contrary. (1) Any coal or lignite found at chase the right of ingress and egress. This will require the the surface is not a mineral and thus belongs to the surface lessee to make arrangements with the surface owners be- owner. The term "at the surface" means "on the surface." (2) Any fore entering to explore or produce on the property. At the coal or lignite found near the surface is not a mineral and be- same time, the mineral owners giving up this right are not longs to the surface owner if any reasonable method of produc- deprived of any bonus, delay rentals or royalty payments. tion will destroy, consume or deplete the surface. The term near In Texas, the mineral lessee has the implied right to use the the surface means within 200 feet of the surface. (3) Any coal surface estate for exploring and producing minerals. Such or lignite situated both within and below 200 feet of the surface mineral rights are superior to the right of the surface owner to again belongs to the surface owner if production will destroy, the extent that they are reasonably necessary for the develop- consume or deplete the surface. (4) Reclamation or restoration ment of the mineral property. The courts have moderated this of the surface after production is immaterial. (5) The value of rule somewhat. However, the surface owner still may wish to the substance being removed is irrelevant. protect and preserve the surface by securing an independent Following the Reed v. Wylie decision, the Texas Supreme contractual arrangement. Competent legal assistance when pur- Court was asked to decide whether the phrase oil, gas and oth- chasing land is indispensable. er minerals, includes uranium. On June 8, 1983, the high court reversed a prior opinion and ruled that the surface-destruction Negotiating Terms test no longer applies to uranium in Moser v. U.S. Steel Corp., of Mineral Exploration 676 SW 2nd 99. The term minerals include uranium regardless Mineral owners who anticipate extensive exploration of their of the depth and regardless of the production technique used to property should negotiate lease provisions that will protect produce it. However, the surface-destruction test still applies to their interests. uranium for all transactions entered prior to June 8, 1983. Finally, the court reiterated what prior opinions had held in Exploration Techniques Texas. The term minerals or oil, gas and other minerals does not Oil companies use a geophysical survey to search for under- include limestone, caliche, surface shale, building stones, sand, ground geological structures favorable for the accumulation of gravel and water regardless of whether the water is located on hydrocarbons. The survey is an attempt to locate structural traps the surface or in the ground. These substances belong to the formed by a dome-shaped impermeable rock layer covering a surface owner unless they are specifically mentioned in the layer or layers of permeable sand. The survey may reveal the reservation or grant. presence of a trap but not the presence of hydrocarbons. So, here is the present status of the law in Texas. The term Several devices are used to conduct geophysical surveys, minerals or oil, gas and other minerals includes, as a matter including seismographs, magnetometers, gravity meters and a of law, oil, gas and uranium. The surface-destruction test still torsion-balance system. With the exception of the seismograph, applies to uranium for conveyance occurring prior to June 8, these devices measure the gravitational pull of subsurface rocks 1983. In addition, minerals include sulphur and salt. to locate the structural trap. The seismograph is the most widely The reservation or conveyance of minerals or oil, gas and used device on shore. other minerals does not include limestone, caliche, surface A seismic test measures acoustic waves bounced off subterra- shale, building stones, sand, gravel and water. Likewise, the nean structures. Acoustic waves are generated in several ways: term or terms does not include coal, lignite and iron ore that lie by blasting dynamite from a shot hole drilled several hundred on or within 200 feet of the surface if production will destroy feet in the ground; by dropping a heavy weight known as a or deplete the surface. thumper from a truck; or by shaking the ground with a device Other Surface Protection Measures known as a vibrasizer. The acoustic waves travel downward and outward; they are However, surface owners may pursue the following where reflected back to the surface by underground structures. The they clearly own no rights to the minerals: reflected signals are monitored on the surface by seismometers

3 (or jugs) connected to a line laid along a predetermined course. tests conducted pursuant to an oil and gas lease. However, The line is connected to an oscillograph that records the signals. liability for damages arises when the tests were not reasonably With the advent of 3-D seismic in the 1990s, the lines and necessary or when they were conducted negligently. seismometers are more concentrated. Landowners may want Because the damages suffered from geophysical tests can more payment to consent to 3-D seismic tests and negotiate outweigh any resulting monetary benefits, mineral own- stronger surface-damage provisions. ers should carefully consider geophysical operations when negotiating an oil and gas lease or when granting the right to Permission for Exploration conduct geophysical tests apart from the lease. There are two Before oil companies may conduct exploratory tests for po- ways of approaching the issue when negotiating the lease. One tential drill sites, they must secure permission from the mineral is to prohibit geophysical operations without the mineral own- owner. If the land is under lease, the mineral lessee’s consent er’s prior written consent. This defers negotiating the seismic is needed. The surface owners and surface tenants may be con- agreement. The other is to negotiate and include the terms of tacted to avoid conflicts, but their permission is not required by the seismic agreement in the oil and gas lease. The agreement Texas law. However, this section of this report is based on the should be tailored to the needs of the particular tract. assumptions that the mineral and surface estate are owned by the same person, and the minerals are not under lease. Lease Considerations Permission from the mineral owner may be granted in one of In the agreement, the mineral owner should specify who or two forms. The oil company may acquire an oil and gas lease what entity is liable for all surface and subsurface damages that, among other things, grants to the lessee the exclusive right and how the payments will be apportioned among the mineral to explore. Or, the oil company may acquire permission only to owner, the surface owner or the agricultural-surface lessee. conduct geophysical tests. If the tests prove positive, an oil and The mineral owner should determine how the monetary gas lease may be sought. value of the damages will be ascertained and when dam- ages must be paid. Many mineral owners require an adequate Liability for Geophysical Trespass security deposit before the tests begin. The monetary value of But what happens if a geophysical trespass occurs? In other damages may be assessed by a qualified appraiser. words, what are the legal consequences of a geophysical The mineral owner should establish test site boundaries. This survey that is conducted without the company first securing involves restricting the shot holes, or other means generating proper consent? the waves for seismic operations, to a safe distance from water The answer depends, in part, on whether the trespass was wells, dams, foundations of homes and other structures. conducted in good faith or in bad faith. Vehicular travel should be disallowed when the ground is so A good faith or innocent trespass occurs when the surveyor saturated with moisture that ruts exceeding a specified depth honestly believes that permission to enter and conduct the tests will occur. Cables and seismometers still can be pulled or car- has been secured. In such cases, the innocent trespasser is li- ried across the property for the tests. able for all damages suffered by the surface and mineral owner. Routes of egress and ingress the crews must use while con- Damages are divided into four categories: (1) physical damages ducting the survey should be established, and a map provided to the land caused by the trespass, such as damages to fences, with the proposed route of the survey platted. The mineral water wells, crops, improvements and roads; (2) monetary owner can stipulate that if the surveyor deviates from the value paid to the mineral owners in the area for permission designated course, the permit will be terminated or liquidated to enter and survey. If the data collected from the survey are damages imposed. Whether fences can be cut, how they must not kept confidential, the innocent trespasser also is liable for be braced before cutting and how they will be repaired are (3) lost value of leasing the minerals if the survey indicates no other considerations. underground structural traps and (4) value of the sale if the data The agreement should describe how the land may be cleared are sold. prior to tests and how it must be cleaned and restored. Usually A bad faith trespass occurs when the surveyor knowingly or land is cleared when the crew lays the seismic line. Clearing maliciously enters to conduct tests. When a bad faith trespass also may be necessary when new roads are constructed. In any occurs, the trespasser not only is liable for the same damages event, the mineral owner should require all brush to be stacked as the good faith trespasser but also is liable for punitive dam- and burned; damaged or removed trees should be cut for ages. Punitive damages may greatly exceed the actual dam- firewood, with the limbs and stumps burned or removed. Rocks ages in certain cases. However, no punitive damages may be exceeding specific dimensions should be removed or placed in awarded unless actual damages first can be proven. designated areas. The agreement should specify that all holes and ruts be back- Geophysical Explorations Under Lease filled, all mounds leveled, topsoil replaced and, perhaps the Texas has unique laws regarding geophysical surveys con- area reseeded where surface damages are more extensive. In ducted pursuant to an oil and gas lease. Texas case law has addition, the cut line should be back-dragged and the ground held that the mineral lessee has the implied right to conduct leveled as smooth or smoother than before the tests. geophysical surveys unless prohibited by the lease. Oil and gas The agreement should address how much the mineral owner leases generally do not prohibit such surveys but instead grant will be paid for allowing the survey. The mineral owner gener- the lessee the exclusive right to conduct such tests. ally receives an amount customary in the area. This may range Texas law also has held that the lessee has no legal obliga- from a payment per shot hole to a fee for the length of line laid. tion to restore the surface or pay surface damages for geophysical

4 A daily fee for the number of personnel and vehicles entering Division Orders the land may be paid also. In addition, the mineral owner should consider whether the Not all mineral owners are familiar with division orders seismic agreement may be assigned to a third party once the because they are not issued until production begins. Division mineral owner has consented. orders are revocable agreements signed by the mineral owners Possible damage to water wells should be addressed. The directing the distribution of proceeds from the sale of oil, gas, mineral owner may require the replacement of a damaged casinghead gas or other related hydrocarbons. The division well with one of equal quantity and quality. If one cannot be order becomes effective only after the oil or gas comes into the located on the property, the mineral owner may ask for water to purchasers possession. It is not a sale of the oil or gas in the be piped in or for property damages because of diminished or ground. lost water supply. The mineral owner may want water samples In addition to being a sales contract, division orders also to be taken by a third party prior to and 15 to 30 days after the insure that the proper parties (or owners) are paid the cor- tests to preserve any evidence of damage to water wells. rect amounts. Division orders state (or declare) the fraction of Some mineral owners attempt to obtain copies of the survey production each party is entitled to receive. The precise figure results. This may be difficult. However, a copy of the data is contained in a fraction carried out to a minimum of seven acquired from the tests may be a good substitute. Interpretation digits, though eight decimal points frequently are used. The of the data may vary. specified ownership interest is derived from a title opinion The following are other considerations: rendered by an attorney working for either the purchaser or • A requirement that gates be kept closed and possibly lessee (producer). Each interest owner will be asked to sign locked—liquidated damages can be imposed for each time (or execute) the division order before the first royalty check is gates are left open. issued. Division orders can do more than simply state each party’s • Inclusion of an indemnity agreement holding the mineral interest. Additional provisions may be included that may or owner harmless from judgments, attorney’s fees or both may not comply with the original lease terms. Here is the di- arising from the surveyor’s activities on the property. lemma faced by mineral owners who are sent a division order • Instructions for repairing the surface above the shot holes. for execution. If they sign the division order containing terms Taxation of Payments contrary to the original lease, will the division order amend or supplant the lease? Is the execution of the division order a The fee paid the mineral owner for the right to enter and prerequisite for receiving the first royalty check? Is it necessary survey is sometimes called a trespasser’s fee. It is a separate for all parties named in the division order to sign before any and distinct fee from the payment for surface and subsurface party gets paid? damages. Further, the two are taxed differently. Apart from any specific statutory law or case law that a Payment for permission to enter and survey is taxed as particular state might have, the answers to these questions ordinary income. Payment for damages to the land (as opposed generally are held as follows. to damages to growing crops) reduces the owner’s basis in the First, a division order can never permanently amend or sup- property. The payments are not taxed until they exceed the plant the lease. If the terms of the division order differ from the property owner’s basis in the land. After that, they are taxed lease, however, the division order controls until revoked by as capital gains income if the land has been owned for more the mineral owner. The mineral owner has no recourse against than six months. However, all payments received pursuant to the purchaser or lessee for any variances during the interim. geophysical tests are presumed to be for permission to enter See Sections 91.402(g) and (h) of the Texas Natural Resources and survey and not for damages to land. Code. The mineral owner may wish to require the lessee to prepare Second, execution of the division order may be required as a a written itemized account disclosing how the payments were condition for receiving a royalty payment. Section 91.402(c) (1) computed. The itemized account would be indispensable in a of the Texas Natural Resources Code provides that the mineral tax audit. owner must sign the division order if it contains ONLY the fol- Above all, parties to an agreement must remember to place lowing items: all the terms and conditions in writing. Oral promises are dif- (A) the effective date of the division order; ficult to prove in a court of law. (B) a description of the property from which the oil or gas is Division Orders being produced and the type of production; (C) the fractional and/or decimal interest in production and Royalty Checks claimed by payee (royalty owner), type of interest, certification Mineral owners or their attorneys frequently fail to properly of title to the share of production claimed, and, unless other- address the treatment of division orders and royalty checks wise agreed to by the parties, an agreement to notify payor at when negotiating an oil and gas lease. If overlooked, the min- least one month in advance of the effective date of any change eral owner could lose not only money but also many beneficial in the interest in production owned by payee and an agreement lease terms acquired during the negotiation process. to indemnify the payor (purchaser) and to reimburse the payor for payments made if the payee does not have merchantable title to the production sold;

5 (D) the authorization to suspend payment to payee for pro- notice by mail of the delinquency. The purchaser has 30 days duction until the resolution of any title dispute or adverse claim after receipt either to pay the royalty or to explain the reason asserted regarding the interest in production claimed by payee; for delay. (E) the name, address and taxpayer identification number of Section 91.402(b) of the statute describes three circum- payee; stances when the purchaser is excused from paying interest. (F) provisions for the valuation and timing of settlements of These are when (1) a dispute concerning title affects distribu- oil and gas production to the payee; and tion of payments, (2) a reasonable doubt exists concerning the mineral owner’s entitlement to the royalty payments and (3) a (G) a notification to the payee that other statutory rights may title opinion places in issue the title, identity or whereabouts of be available to payee with regard to payments. the royalty owner that has not been satisfied after a reasonable The purchaser may not withhold royalty payments solely request has been made. because an owner refuses to sign a division order not in Section 91.402(f) also provides that royalty payments may be compliance with Section 91.402(c)(1). However, if the owner remitted annually, not monthly, if the aggregate amount owed refuses to sign a division order consistent with the section, the the royalty owner during the preceding 12 months does not purchaser may withhold royalty payments without interest. exceed $100. Note: Section 91.402(c) et seq., effective August 26, 1991, For the best protection, mineral owners should address these was added by the 72nd Texas Legislature to cure problems as- issues in the lease and not rely solely on the Texas statutes. Al- sociated with division orders. However, it created others in at ternatives the mineral owner may negotiate regarding division least two respects. orders include the following: First, Section 91.402(c)(2) provides that a division order • A division order tendered to the mineral owner shall containing only the six enumerated items ". . . does not amend comply strictly with Section 91.402(c)(1) as illustrated in any lease. . . ." However, if such a division order did contain Section 91.402(d) of the Texas Natural Resources Code. conflicting provisions, which instrument controls, the division However, the division order may not alter the leases valua- or the lease? tion of the royalty nor change the Texas case law definition Second, Section 91.402(i) provides that a division order may of the terms market value, market price, prevailing price in be used to clarify royalty settlement terms. As such, the terms the field, proceeds or other such language. market value, market price, prevailing price in the fieldor other • The execution of any division order containing provi- such language is statutorily defined as "the amount realized at sions contrary to the lease terms will not temporarily nor the mouth of the well by the seller of such production in an permanently alter or amend the original lease terms. All arms length transaction." such contrary terms may be stricken before executing the The problem is that the statutory definition of the terms alters division order. Texas case law. The terms are not synonymous according to the Texas courts. Furthermore, the deductible costs from the royalty • Acceptance of any royalty payment pursuant to the divi- may vary with each term according to Texas case law. sion order shall not constitute a full or final settlement for And finally, all parties need not sign the division order before any past royalties or interest payments that may be due the a single party is paid. However, the purchaser or lessee has sole mineral owner. discretion in the matter. • The division order shall be cancelable or revocable at all The mineral owner may encounter other questions and prob- times. Section 91.402(g) provides division orders are revo- lems apart from the terms of the division order. For instance, cable by either party on 30 days written notice. how soon after production commences will the first royalty • The mineral owner shall be paid on the execution of the check be issued? After the first royalty check is received, how division order. He or she need not wait for all parties frequently will subsequent checks be rendered to the lessor? specified in the division order to sign. If a royalty check is delinquent or withheld, will the mineral • The mineral owner shall not give any warranty of title in owner receive interest on the unpaid balance? the division order beyond that contained in the lease. The answers to these questions are governed both by the • The division order shall not constitute a ratification of the lease terms and Texas statutory law. Unless the lease contains oil and gas lease or any oil or gas purchase contract— terms to the contrary, Section 91.401 et seq. of the Texas whether revocable or not—or any other contract or agree- Natural Resources Code provides that the first royalty payment ment covering the leased premises or its production. must be tendered within 120 days after the end of the month in which the first sale of production occurs . Thereafter, subse- • The terms of the original lease contract cannot be altered quent royalty payments are to be tendered within 60 days after or amended except by a separate written instrument the end of the month oil production is sold and within 90 days clearly defining its purpose and effect. The written agree- after the end of the month gas production is sold. ment shall describe the specific terms or provisions being If royalty payments are not forthcoming within the desig- altered and the proposed change or modification. It must nated intervals, the royalty is to draw interest at a rate 2 percent be executed by the party against whom the amendment above the rate charged on loans to depository institutions by or alteration is sought to be enforced. Any memoranda or the New York Federal Reserve Bank. A different interest rate will attachments to a royalty check shall be null and void and be charged if the lease so states. without legal significance for the purpose of altering the As a prerequisite for royalty accruing interest under the original lease contract. Texas statute, the royalty owner must give the purchaser written

6 Note: In light of the 1991 changes to Chapter 91 of the Texas the court's decision to ignore the unequivocal intent of sophis- Natural Resoucres Code, the effectiveness of some of the prior ticated parties who negotiate contractual terms at arm's length." suggestions may be questionable until the Texas courts and To avoid the consequences of this decision, mineral owners legislators resolve some apparent contradictions. may require the oil companies to reimburse royalty owners for the post-production. This allows the deduction in lieu of the Royalty Checks Heritage decision but contractually requires their reimbursement. Lease provisions dealing with royalty checks also may be ne- Also, mineral owners may negotiate a lease provision hold- gotiated. The following suggestions contain the essence, not the ing the oil company, purchaser or both liable for the loss of oil precise language, of lease clauses pertaining to royalty checks. or gas once it leaves the leased premises. • The first royalty check shall be tendered to the mineral Mineral Owners' Options owner within 90 days after the end of the month the first production leaves the leased premises (or some reasonable If the oil company refuses to include any of the provisions in time). (Generally, it takes 90 to 120 days for the title opin- the lease, or if the mineral owner is presented a division order ion to be secured by the purchaser or lessee. Sometimes it for execution without having addressed these issues in the takes longer depending on the number of interest owners lease, the mineral owner may want to proceed in the following in the production unit.) manner. First, the mineral owner may alter the division order so it • If the first royalty check is not tendered within 90 days conforms to the original lease terms. This can be done by strik- after the end of the month when the first production leaves ing all contradictory or questionable language and then initial- the leased premises, interest shall accrue on the unpaid ing the margins where the deletions and changes occur. royalty at the highest rate allowed by state law. The first Second, he or she could attach an addendum to the division royalty check shall contain all accrued interest. (Some order incorporating these suggested alternatives. Typically, the mineral owners tie the interest to the prime rate. Others addendum would begin with wording similar to the following: designate a fixed rate such as 15 percent, but always less "Notwithstanding anything to the contrary contained in the than a usurious rate.) attached division order rendered by the XYZ Company, the fol- • If the first royalty check is not tendered within 180 days lowing terms and provisions control. . . ." after the end of the month when the first production leaves Naturally, the purchaser or oil company is responsible for de- the leased premises, the lease shall terminate. The only ciding whether to issue royalty checks based on such a revised exception shall be when a valid division order title opin- or amended division order or one not in compliance with Sec- ion has been rendered depicting serious title problems. tion 91.402(c)(1) as illustrated in Section 91.402(d) of the Texas However, all title problems must be cured within 30 days. Natural Resources Code. However, it is a means by which the Otherwise, the countdown toward the 180-day limit will mineral owner may receive royalty payments yet preserve the continue. rights stated or negotiated in the original lease form. • Once royalty checks have been tendered, the mineral Successful negotiation of an oil and gas lease requires owner will be paid within 60 days (or some reasonable knowledge of the lease terms, common sense, foresight and time) after the end of the month when the production diplomacy. Even with knowledge of lease provisions, a mineral leaves the leased premises. If the payments are not forth- owner easily can overlook the problems associated with divi- coming within the designated period, interest will again sion orders and royalty checks. Therefore, treatment of division accrue on the unpaid balance. If more than six months orders and royalty checks should be on the agenda of every oil transpire between royalty payments, the lease shall expire. and gas leasing transaction. An exception may be included when the annual accrued This report is for information only and is not a substitute for royalty payments do not exceed $100. legal counsel. It is a combination of three Real Estate Center A royalty interest is sometimes referred to as a cost-free publications: A Thin Layer of Rights, Negotiating Terms of Min- interest because it bears no exploration and production costs. eral Exploration and Division Orders and Royalty Checks. However, it does bear a pro rata share of post-production costs based on the size of the lease royalty. Post-production costs For More Information include items such as transportation, compression separating Hints on Negotiating an Oil and Gas Lease, report 229, and so forth. http://recenter.tamu.edu/pdf/229.pdf. In the past, mineral owners who wanted to avoid post-pro- "Rights and Responsibilities of Mineral Cotenants," reprint duction costs negotiated contractual provisions in the oil and 843, http://recenter.tamu.edu/pdf/843.pdf. gas lease. Basically, the lessee agreed to bear all the post-pro- duction costs in the mineal owners' behalf. Termination of an Oil and Gas Lease, report 601, http:// In 1996, the Texas Supreme Court reviewed the enforceabil- recenter.tamu.edu/pdf/601.pdf. ity of these lease provisions. In Heritage Resources Inc. v. Na- "Subdivision Drill Sites," reprint 690, http://recenter.tamu. tionsBank, No. 95-015, 4/25/96, the court ruled that whenever edu/pdf/690.pdf. the value of the royalty is set "at the well" or "the wellhead," the lease clauses freeing the royalty of post-production costs are surplusage as a matter of law, i.e., null and void, useless, unen- forceable. A dissenting judge wrote, "The author is puzzled by 1109-840

7 MAYS BUSINESS SCHOOL Texas A&M University http://recenter.tamu.edu 2115 TAMU 979-845-2031 College Station, TX 77843-2115

DIRECTOR

GARY W. MALER

ADVISORY COMMITTEE

DAVID E. DALZELL, CHAIRMAN D. MARC McDOUGAL, VICE CHAIRMAN Abilene Lubbock JAMES M. BOYD BARBARA A. RUSSELL Houston Denton CATARINA G. CRON DOUGLAS A. SCHWARTZ Houston El Paso TOM H. GANN RONALD C. WAKEFIELD Lufkin San Antonio JACQUELYN K. HAWKINS JOHN D. ECKSTRUM, EX-OFFICIO Austin Conroe

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